Initial Public Offering
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Initial public offering refers to the sale of shares of a company to the public for the first time. Companies conduct an IPO due to several reasons. Arikan and Capron (2010), state that one of the reasons companies conduct IPO is to raise capital for expansion. In addition, private companies conduct IPOs in order to convert and become public companies. Companies should consider raising finances through an IPO instead of other sources of financing due to several reasons. It is not a requirement for a company to pay back money raised through an initial public offer. According to Brigham & Ehrhardt (2011), companies should raise finances through an IPO instead of using bonds and other debt securities since such securities need to paid back by the company. However, critics argue that IPOs are not a convenient way of raising finances since the original owners of a company that wants to go public may lose part of their ownership (Espinasse, 2011).
An IPO has several impacts on the valuation of a firm. Baker & Nofsinger (2010) argues that most stock prices of companies increase after it conducts an IPO. Before a company goes public, a few private owners who control the stock of this company own it. After a company goes public, it sells its shares to potential investors in the stock market. The market forces of demand and supply control the prices of the shares that are sold in the stock market. The market price of such shares is likely to increase because of market forces of demand and supply (Bragg, 2009). An IPO may also cause the stock of a particular company to become underpriced. Underpricing occurs when a company goes public at a price that is lower than its first day closing price. Companies underprice their stock due to several reasons. One of these reasons is the existence of information asymmetry in the market. Chambers & Dimson argue that uniformed investors bid for the price of a particular share without considering the quality of the IPO. In contrast, informed investors only bid for an IPO that they think will make them earn maximum returns. The difference in information between informed investors and uninformed investors may lead to the underpricing of a company’s stock. Investment bank conflict theory can also explain why the stock of a particular company may become undervalued during an IPO. According to this theory, investment banks arrange for the underpricing of a particular stock in order for them to benefit themselves (Cumming, 2009). Stock regulators in most countries have considers putting high IPO commissions as a way of reducing the underpricing of stock. It will help in ensuring that the stock of a particular company is not lower than the true value of this company leading to undervaluation of the company.
IPO also has great impact on the financials of a particular company. It increases the shareholders equity due to the value of shares that are issued at par. Draho (2004) states that the cash flow statement also changes since the cash flow from financing activities increases after a company raises finance through the sale of shares. Some of the companies that raise finance through the IPO decide to use the money raised to pay off their long term debts. It will cause the long-term debts of a company to reduce (Espinasse, 2011). Other companies purchase more assets after conducting an IPO. This will increase the fixed assets section of the balance sheet of a company. The income statement of a company also changes after a company raises money through an IPO. The overhead expenses increase since it will have to pay for accountancy fees, legal fees and underwriting expenses. The interest rates that a company uses to pay its loans also reduce when it pays part of its loans after financing an IPO.
Draho (2004), outlines the three main stages that an IPO process goes through. They include pre-IPO transformation phase, IPO transaction phase and the post-IPO transaction phase (Cumming, 2009). In the pre-IPO transformation phase, the company should consider hiring top quality management team that will help the company in its transition after the IPO process succeeds. Chambers & Dimson (2009), added that the management of a company should also consider re-examining their policies and processes so that they match the strategy that a company seeks to adopt after the IPO process succeeds. During the pre-IPO transformation, a company formulates its business strategy that will guarantee its growth. Potential investors use the business strategy formulated during the pre-IPO transformation stage to make decisions on whether to purchase certain shares.
The IPO transaction phase takes place just before a company trades its shares to the public. Underwriters should be keen in this phase while calculating the true value of the private company that wants to go public (Bruton et al, 2009). The value they place on a certain company will determine whether investors will purchase the stock of this company. The strategy that most companies use to create public confidence during this stage is by hiring law companies and accounting firms that have a good reputation to assist in the IPO process. During the post-IPO stage, the company participating in an initial public offer tries to achieve the goals that it outlined in its prospectus. Examples of these goals include the growth rate that a company sought to achieve and the earnings estimates it wished to attain.
According to Bragg (2009), companies conduct an IPO in order to diverse their equity base. This will help in ensuring that a company does not only rely on retained earnings as its only source of equity. In addition, IPO helps a company to enlarge its equity base and facilitate any expansion projects that it may be considering. Brigham and Ehrhardt (2011), supported the argument of Bragg (2009), by stating that IPOs help companies to raise a large amount of capital within a short time leading to an increase in the capital base of a company. They enable a company to tap a wide pool of investors in the stock market. Companies are also able to conduct a rights issue after they raise finances through the IPO. This will help a company to get additional sources of funding to be used for expansion purposes without incurring extra cost of capital. A company is, therefore, able to have large capital base to enhance its future growth and expansion efforts.
The public image of a company also improves when it becomes listed due to an IPO. The public views a listed company as successful due to raising finances through the stock market. This will help the company to increase its market share and profitability. IPO also helps in creating public awareness of a company. Before a company conducts an IPO, it needs to advertise itself in newspapers and other advertising media. Improved public awareness of this company helps to boost its sales (Boulton, Smart & Zutter, 2010). A company also does not need to repay the capital raised through an IPO. It shows that it is an efficient source of financing.
Baker & Nofsinger (2010), argue that employees also benefit when a company goes public. Some companies introduce stock based compensation incentives shortly after issuing an IPO. These programs help in increasing the productivity of a company, since employees will be motivated to perform their tasks more efficiently. Stock based compensation programs also help to align the interests of the employees with the interests of the company, thus, ensuring that the company retains its qualified employees (Jain & Kini, 2012). Company loyalty may also benefit from such approach Klein (2005), states that once a company goes public successfully, it has a great advantage during mergers and acquisition, because it is able to use its common stock to acquire other public and private companies. Additionally, IPO helps in increasing the liquidity of the shareholders. Shareholders can sell the shares bought from an IPO at a later future date and earn capital gains. In addition, the founder of the company can sell a part of his stock during an IPO.
IPO faces several challenges. Mandura (2009), argues that one of the most common challenges that a company faces when it goes public is that it will need to add more disclosures to the investors. Before going public, the company needs to publish a prospectus. Prospectus reveals the information about the operations that a company engages in. Examples of such information include the compensation of the executive staff of a company, all the transactions that a company conducts and prior violations of the securities laws that a company might have engaged in (Lewis, 2007). The shareholders are also supposed to be involved in the decision making process when a company decides to go public. It may make a company to be inflexible and increase the length of the decision making process. The initial public offer process is also very expensive. Companies will be required to pay underwriters a specific commission for the services that they offer to them. In addition, a company that decides to go public will need to hire lawyers to provide assistance on the legal drafting of documents (Palmiter, 2008).
Financial analysts argue that the cost of financing an IPO ranges from $250,000 to $1 million (Palmiter, 2008). If a company is not able to raise this amount of money, it might not be able to finance a successful IPO process. Padberg (2007), supported the argument of Palmiter (2008), by stating that an IPO is very expensive since a company would need to pay accounting and auditing fees, filing fees, printing fees, underwriter expense allowance and travelling costs. An IPO process also disrupts the normal activities of an organization. The management of an organization may not be fully aware of how to conduct an IPO process. This may require a company to train its staff so that they know how to conduct an IPO.
Krishnan et al. (2011), state that a company exposes itself to the risk of civil liability suits after it goes public. If a company includes any misleading statements when it publishes documents to be used in the IPO, the directors and executives face the risk of legal liabilities. In addition, after a company goes public it is required by the SEC to file its reports. If the officers publish any false information in the reports, they are liable for misrepresentation (Palmiter, 2008). Management of public companies also faces the pressure of increasing the earnings of a company, as the shareholders always want positive returns on their investments. A company may not carry out capital-intensive projects, since it will decrease the amount of dividends earned by the shareholders.
Overall, an IPO is critical for the financial success of any company. It helps a company to raise enough funds for expansion. In addition, companies use the money raised from an IPO to fund their research and development projects. An IPO also helps a company to enhance its public image. Consumers view a company as financially strong if it is able to raise finances by trading shares in the stock exchange. Underwriters play a big role in the success of an IPO. Most organizations select reputable companies such as investment firms so that they can act as their underwriters. Underwriters are responsible for determining the most appropriate price to issue stock. Moreover, underwriters design the prospectus for issuing shares and ensuring that a company meets all its disclosure requirements. An IPO process follows three major stages. These include pre-IPO transformation stage, IPO transaction stage and post-IPO transaction stage. A company should follow all these stages keenly to ensure that the whole IPO process is successful. Critics argue that companies should not raise finances through an IPO, since the whole process is expensive. A company incurs fees such as legal fees, printing fees and accountancy fees. In addition, after the company conducted the IPO, it becomes exposed to many legal liability risks.